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6 Reasons to Purchase an Apartment Property
A multifamily property with five or more units, also known as an apartment complex, is an incredibly common investment vehicle . Make no mistake, buying and maintaining ownership of an apartment complex is a big decision that often comes with a ton of responsibility. Regardless of the difficulty involved, however, most investors agree that owning an apartment building can be highly financially advantageous for these 6 reasons:
- Apartment properties provide less risk than other common assets
Buying and maintaining an apartment property is costly, there is no doubt about that. Even so, multifamily properties with 5 or more units reduce risk and increase profit potential for an investor because of the large quantity of units. One of the most valuable aspects of apartment property ownership is that unlike owners of single-family homes, apartment owners can still count on having rental income from other building units if a tenant moves out.
Another key mitigator of risk when it comes to apartment property ownership is the owner's ability to protect, or, in a way, diversify their revenue stream by having a larger tenant mix. Owners of apartment buildings have a decent amount of control over their tenant base (providing the property has no affordability component), and thus can decide what credit and finance parameters they will accept from potential tenants. Some would immediately consider setting strict eligibility requirements, but leaving room for higher risk tenants is a useful strategy for filling more units. This is not nearly as big of a risk as with a single family property, because there should also be tenants with more agreeable financial profiles to ensure that there are no choke points with the income produced.
Apartment property owners also have the option to stagger lease agreement start-dates. Strategically speaking, the ability to manage the rent roll in such a way that maturation dates don't all fall in the same time period is a severely underrated skill. A smart investor can utilize this power to plan and distribute leases accordingly and more or less ensure that there is low risk in each financial quarter, even if a few tenants are lost or decide not to renew their lease.
- Operating, maintenance and renovation costs can be spread among units
Depending on utilities and additional third party expenses, there is a lower per-unit operating expense than with other real estate assets. More importantly, should something unexpected occur that leads to expensive repairs - such as the all too common need for a roof replacement - the cost can be spread out between all of the units, greatly lowering the burden of the owner.
Circling back to utilities, Many newer properties are set up so that each tenant can be billed directly for their utility usage, another huge burden taken from the property owner. With older properties where units are not individually metered for utilities, many property owners use the Ratio Utility Billing System or “RUBS”. RUBS is a common method for determining a resident’s utility bill based on their unit’s square footage, the number of people living in the unit, or a combination of both.
While not an exact function of the property itself, renovations can also be considered less expensive if looked at from a per-unit basis. After all, buying materials in bulk can lead to some impressive savings.
- Apartment properties are tax-efficient assets
Apartment properties fall under the umbrella of commercial real estate. Even so, the use of such an asset is still viewed as residential. Because of this, apartment owners enjoy a few interesting benefits such as a depreciation schedule that is much faster than other commercial assets for starters.
Another such benefit is that apartment owners are eligible to utilize the mortgage interest deduction that residential mortgage owners are allowed. This means that they can deduct the interest from the loan on their apartment property for a value up to $1MM. As an added benefit, when refinancing a property for more than its original value, apartment owners can deduct additional amounts of interest and fees --as long as the extra funds can be proven to have been used to improve or maintain the property.
- Apartment investments are a hedge against inflation
Inflation is when the prices of goods and services rise, thus creating a scenario where consumers have less buying power. There are a few investment vehicles unhindered by inflation, and some that may suffer as a result of it. With an apartment property, it is the former and not the latter.
Apartment property owners collect rent on a timely basis at set intervals, and rent rises right along with inflation. In general, the average apartment lease has a term of one year. This allows a landlord to closely monitor the rents of comparables in the same market. With the right strategy and enough timing, the rental rates can be adjusted to move up with inflation. This is a unique advantage for apartment owners, since most other commercial leases are typically locked for three or five years or increase at 1% annually.
- Loan approval for apartment financing is based more on the property’s financial characteristics than the borrower’s
In almost any lending scenario, the financial health and credit status of a borrower will make or (more than likely) break a deal. Lenders take a borrower’s finances under heavy scrutiny to ensure that they don’t originate loans that expose them to too much risk. This holds true across most lending scenarios, but is much less important in the case of apartment investing.
With [multifamily finance](), lenders tend to be more focused on the profit-generating potential of any given property than on the investor’s finances or credit. The lender’s main concern is whether the property’s income is enough to exceed the required payments from the investor. The metric of importance here is the property’s Net Operating Income or NOI.
NOI is calculated by taking the gross rent produced by a property and subtracting operating expenses from that figure. The resulting net operating income is what is expected to cover the loan payment and provide the ability to distribute income to owners and/or investors.
- Apartment properties provide more opportunities to generate supplemental income.
Even as an income producing asset in nature, owning an apartment building can lead to income streams beyond just rent. Investors have a plethora of opportunities to generate additional income from their property through amenities, like a laundry room, gym, pool, or office space. In some scenarios, even additional parking spaces for units can be monetized.
The cost of investing in amenities such as these for a property can be spread out between all of the units, so It is no problem for the owner to recoup the costs by charging for these amenities. As an investor or owner, being able to reduce even the smallest of recurring expenses can lead to net savings in the thousands.
What are the advantages of investing in an apartment building?
Investing in apartment buildings can provide a variety of benefits. According to Apartment.loans, some of the most substantial benefits include:
- Cash flow: While some types of investments, such as dividend stocks and annuities, provide some degree of payments to investors, they generally don’t hold a candle to the amount of cash generated by apartment buildings.
- Leverage: Apartments have the massive benefit of allowing borrowers to put down around 20% to 30% of the sale price while financing the rest over a 25-30 year amortization period. In general, stocks, bonds, mutual funds, and other types of investment opportunities offer nothing of the sort.
- Tax Incentives: Multifamily real estate is an ideal investment from a tax perspective. Not only can investors take substantial mortgage interest and depreciation deductions, but they can also often deduct travel and utility costs, as well as other expenses.
- Equity growth: Just like a single-family home, as time goes on, an investor will generally build up equity in their property as their mortgage is paid off. In addition, equity will increase if the property itself increases in value.
- Syndication/partnership potential: While most stock or bond investors invest by themselves, apartment complexes are an ideal investment for groups. By teaming up with other investors, you can purchase larger and better properties, maximizing your potential profits.
- Supplementary income: Though rental payments from tenants are typically the most substantial source of income for an apartment complex, other sources of income can make a serious difference. The most common supplemental income sources include laundry machines, vending machines, and parking spots for non-residents (which can be particularly profitable in upscale urban areas).
According to Multifamily.loans, investing in apartment buildings early can also provide the following benefits:
- Compounding returns: Over time, small amounts of money invested into multifamily properties can grow exponentially due to the power of compounding returns. This means that the earlier you start investing in multifamily, the more wealth you’ll have in the long run.
- Diversification: Investing in multifamily properties early can help you diversify your investment portfolio. One of the main benefits of apartment investing is how relatively low risk the asset class is. If the market crashes, that may well wipe out your 401(k) — but odds are, your apartment buildings will be doing just fine.
What are the tax benefits of owning an apartment building?
Owning an apartment building can provide a variety of tax benefits. According to Multifamily.loans, investors can take substantial mortgage interest and depreciation deductions, as well as deduct travel and utility costs, and other expenses. Additionally, according to Apartment.loans, investors can depreciate commercial buildings over a 39-year period and residential buildings over a 27.5-year period. For instance, if an investor purchases a $5 million commercial building, they can take approximately $128,000 of depreciation each year. Lastly, according to Commercialrealestate.loans, investors can deduct a certain amount off of their income taxes each year in order to account for depreciation.
What are the risks associated with buying an apartment building?
When buying an apartment building, there are several risks to consider. These include:
- Utility Billing: Many buildings, especially older ones, have shared utilities. This can be an issue, especially as tenants may overuse utilities if they are not paying the bill themselves, greatly increasing your expenses. However, this issue is commonly addressed by implementing a ratio utility billing system (RUBS), which divides all monthly utility expenses by the number of units in a building, with unit bills being prorated based on the size of a unit, the number of bedrooms/bathrooms, and other factors.
- Contaminants/Health Risks: In addition to having shared utilities, older apartment complexes may contain contaminants such as asbestos or lead paint. These issues typically will need to be remediated by a new owner, which can be very expensive. Ordering an inspection early on in the decision-making process can help you determine whether a building has these issues, and, if so, how serious they are.
- Plumbing Issues: Plumbing can be yet another issue faced by the owners of older apartment buildings. Repairs can be expensive, and additional contamination issues may arise if the building has lead pipes.
- Roofing: While a lot apartment buildings have flat roofs, these can present certain issues, particularly with leakage. Like many of the other considerations we’ve mentioned, a flat-roof is unlikely to be a deal-killer, but it’s still something to keep in mind.
- Wooden Building Elements: Apartment buildings with significant amount of wooden framing, sometimes referred to as “all frame” buildings, can be significantly more expensive to maintain than buildings with brick or concrete exteriors. Potential issues include rot (especially in warmer, more humid climates), and increased fire risk (particularly in drier areas).
- Insurance Costs: Older buildings, as well as those in run-down areas will generally be more expensive when it comes to insurance costs. Potential buyers should always make sure to check current insurance costs, as well as to inquire with other insurers to determine if the current owner is under or overpaying.
Apartments can also be notoriously difficult to manage, especially for first time owners. Many owners choose to outsource this to a property management company, which will likely charge between 10-20% of rents (though flat fee arrangements are also often available). Apartment owners can face additional liability risks, especially for larger multistory complexes, as well as complexes with pools, gyms, and other areas where accidents may be more likely to occur. Safety inspections and legal compliance issues can be both expensive and time consuming (something single family home investors rarely have to deal with). Unlike stock in Google or Coca-Cola, apartment buildings are not particularly liquid, and can be difficult to sell. Even in a seller’s market, it can often take a few months to find a suitable buyer and close the deal. In a market where prices have fallen significantly, it may often be more desirable to hold on the property for a few years until prices rise again.
What are the best strategies for financing an apartment building?
The best strategies for financing an apartment building depend on the expected costs of renovation and the investor's savings. If the renovation is light, such as fixing some holes in the roof and doing some new landscaping work, the investor may not need to tap into additional financing. However, if the renovation is more extensive, such as upgrading the building's HVAC systems or replacing windows, flooring, and appliances, it may be best to take out a loan or look into a line of credit to support the investment strategy.
For first-time multifamily investors, bank loans are a popular option. They may not always have the best terms on the market, but it is easier to find a lender willing to work with a first-time investor. However, loans are nearly always going to be recourse for a first-time investor, meaning if the investor defaults on the loan, the bank can go after more than just the property to cover its losses.
Other financing options for first-time multifamily investors include FHA loans, bridge loans, and hard money loans. FHA loans are government-backed loans that are available to investors with lower credit scores and down payments. Bridge loans are short-term loans that are used to finance the purchase of a property until a more permanent loan can be secured. Hard money loans are short-term loans that are backed by the value of the property, not the borrower's creditworthiness.
What are the most important factors to consider when buying an apartment building?
The most important factors to consider when buying an apartment building are:
- Location: The old proverb “location, location, location” is equally true for multifamily real estate as it is for a single-family home. No matter where you choose to invest in an apartment, it’s extremely important to be confident about the location you choose. Before deciding on a location, an investor should be familiar with area information, including: employment and economic data, economic health of local employers (especially for smaller markets), population and population growth trends, and crime and safety data. Source
- Utility Billing: Many buildings, especially older ones, have shared utilities. This can be an issue, especially as tenants may overuse utilities if they are not paying the bill themselves, greatly increasing your expenses. However, this issue is commonly addressed by implementing a ratio utility billing system (RUBS), which divides all monthly utility expenses by the number of units in a building, with unit bills being prorated based on the size of a unit, the number of bedrooms/bathrooms, and other factors. Source
- Contaminants/Health Risks: In addition to having shared utilities, older apartment complexes may contain contaminants such as asbestos or lead paint. These issues typically will need to be remediated by a new owner, which can be very expensive. Ordering an inspection early on in the decision-making process can help you determine whether a building has these issues, and, if so, how serious they are. Source
- Plumbing Issues: Plumbing can be yet another issue faced by the owners of older apartment buildings. Repairs can be expensive, and additional contamination issues may arise if the building has lead pipes. Source
- Roofing: While a lot apartment buildings have flat roofs, these can present certain issues, particularly with leakage. Like many of the other considerations we’ve mentioned, a flat-roof is unlikely to be a deal-killer, but it’s still something to keep in mind. Source
- Wooden Building Elements: Apartment buildings with significant amount of wooden framing, sometimes referred to as “all frame” buildings, can be significantly more expensive to maintain than buildings with brick or concrete exteriors. Potential issues include rot (especially in warmer, more humid climates), and increased fire risk (particularly in drier areas). Source
- Insurance Costs: Older buildings, as well as those in run-down areas will generally be more expensive when it comes to insurance costs. Potential buyers should always make sure to check current insurance costs, as well as to inquire with other insurers to determine if the current owner is under or overpaying. Source